Current Assets - 38,000,000 ; Net plant, property, and equipment - 101,000,000 ;

Question

Current Assets - 38,000,000 ; Net plant, property, and equipment - 101,000,000 ; Total assets - 139,000,000

Accounts payable - 10,000,000 ; Accruals - 9,000,000 ; Current Liabilities - 19,000,000 ; Long-term debt (40,000 bonds, 1,000 par value) - 40,000,000 ; Total liabilities - 59,000,000 ; Common stock (10,000,000 shares) - 30,000,000 ; Retained earnings - 50,000,000 ; Total shareholders equity - 80,000,000 ; Total liabilities and shareholders equity - 139,000,000

The stock is currently selling for 17.25 per share, and its 1,000 par value, 25-year, 6.25% bonds with semiannual payments are selling for 895.00. The beta is 1.15, the yield on a 6-month treasury bill is 2.50%, and the yield on a 20-year treasury bond is 6.50%. The required return on the stock market is 12.50%, but the market has had an average annual return of 15.50% during the past 5 years. The firm's tax rate is 38%.

a.) What is the best estimate of the after-tax cost of debt?

b.) Based on CAPM, what is the firm's cost of common stock?

Please show work.

Explanation / Answer

Answer:

1. After tax cost of debt = [Before Tax rate x (1-marginal Tax rate) ]

Hence , after ta cost of debt = [6.25% x (1-38%)]

Therefore, After Tax cost of debt = 3.875 %

2. Firms Cost of common stock under CAPM (Re) = rf + (rm -rf) x ?  
Where,Re is Firms Cost of common stock under CAPM

rf is the risk free rate,

rm is the market risk premium

? is the Beta coefficient

Hence, Re = 12.5% + ( 15.50%-12.5%) x 1.15

Hence, Re = 15.95 %

The firm's cost of common stock is 15.95%

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